How Our Investment Framework Identified the Retail Rally

The financial media and economists are almost always late to a trade. That’s because they’re reporting on what has been performing well and are simply extrapolating that performance into the future. Retail stocks are the latest example. There is no shortage of articles and interviews on CNBC pushing investors to buy retail stocks.

You can, of course, make money on a momentum trade towards the end of a rally. However, it’s obviously better to get in at the beginning of a rally than closer to the end. At Variant Perception we use an investment framework that helps clients to identify opportunities in markets.

The Retail Trade:

We recommended retail stocks to clients on October 12th, 2017, less than a month before retail began to rally. The following is a case study into how you can use our data-driven investment framework to consistently find attractive investment opportunities.

In October 2017, retail was universally hated. Retail stocks were getting pummeled, retail stores were closing and the narrative was that Amazon was going to take over the world.

However, like most things in life, the data you look at makes a big difference. If you were to look at what led retail stocks back in October you’d see signs of an opportunity. We wrote in our October report:

Our leading indicators for retail overall are positive, and even the most negative of our leading indicators have turned back up. US workers have been enjoying high stock prices, high home prices, rising wages and have reported high confidence in surveys.

All of these are consistent with higher levels of spending. The most worrisome signs we had seen, which made us negative on retail late last year and early this year, were that rising rental, medical and transportation costs would hurt discretionary spending. All of those have now passed, and consumption should improve.

As you can see, our retail sales leading indicator was positive back in October. This chart shows that our leading indicator (red line) does a good job of leading retail sales by about 6 months.

Our leading indicators led us to believe that retail was poised to break out to the upside. But, that alone doesn’t mean that there is a great trading opportunity, especially if it’s already priced into the market.

Valuations also looked very attractive. Even after adjusting for leases, retail names were extraordinarily cheap.

As we already mentioned, sentiment toward retail was extremely negative. Sentiment is actually a contrary indicator because even marginally better news can cause a rise in equity prices. Retail was hated across the board. In contrast to today, you couldn’t find a positive article on retail and most investors wouldn’t touch retail with a ten-foot pole.

Moreover, money was flooding out of retail.

And short interest was nearly 15%, giving you the added benefit of a short squeeze if retail did, in fact, turn around.

Finally, we had a number of technical momentum signals that were triggering for a variety of retail names that showed likely trend exhaustion.

Since we wrote our report, XRT (the SPDR retail ETF) is up 21.5%. If you were more aggressive, stocks like Foot Locker, Dick’s and Macy’s are up 58%, 37% and 77% respectively.

Variant Perception’s Framework:

The retail opportunity does a great job of highlighting our investment framework.

Economic data can be segmented into lagging, coincident and leading indicators. Lagging indicators are those that lag the market – they tell you where the economy has been. Retail-store closings are a great example in this case. A retailer isn’t going to close a store after one month of bad sales. It’s only after an extended decline that they’ll make the decision and even longer before the stores themselves begin to close.

Coincident indicators tell you where the economy currently is. An example of a coincident indicator, in this case, is retail stock prices. Like store closings, they would lead you to believe that retail stocks were in a dire situation.

It’s only by looking at leading indicators that you can get an idea of where asset prices are likely to move in the future. If you were to look at home prices, wages and consumer confidence (among many others), that provide a lead on retail sales, you would have seen a drastically different picture and seen that retail sales, and thus retail stocks, were poised to bounce.

Moreover, valuations were beaten up, sentiment was negative and our trend exhaustion tools were triggering. This showed us that the forecasted move wasn’t priced into equities and that the timing was likely to be right.

You could describe many of our competitors as “gurus” in that they are smart and likely to have at least one major call under their belt. But, unless they have a rigorous investment framework, can you really trust that they will be correct on their next major call (much less that they’ll be transparent into how they arrived at the conclusion)? By applying our investment framework across countries and asset classes, we’re able to spot asymmetric risk/reward opportunities on both the long and the short side. We’re not always right, but it is our data-driven framework that allows us to consistently deliver profitable trade ideas to our clients.

If you’d like to see more examples of how the VP Framework helps our clients to identify trading and longer-term investment opportunities, please click here to request a trial of our research.

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